1. 1 Lecture 10 Methods of Payment p. 3 Letters of Credit

2. 2 AGENDA: 1.Introduction & Definition 2.L/C: how do they work? 3.Types of L/C according to conditions 4.Types of L/C according to the way they work 5.D/G vs. L/C 6.Recommendations for exporters

3. 3 Letter of Credit (L/C) A L/C is an undertaking by a bank to make a payment to a named beneficiary within a specified time, against the presentation of documents which comply strictly with the terms of the L/C The main advantage is providing security to both the exporter and the importer, but the security offered, comes at a price and must be weighed against the additional costs resulting from bank charges The exporter must understand the conditional nature of the L/C and the fact that payment will not be made unless the terms of the credit are met precisely

4. 4 L/C: explanation A L/C is opened by an importer (applicant), to ensure that the documentation requested reflects and proves that the seller has performed under the requirements of the underlying sales contract, by the exporter by making them conditions of the L/C The sales contract is not an inherent part of the L/C, although the L/C may contain a reference to such contract For the exporter a L/C, apart from cash in advance, is the most secure method of payment in international trade as long as the terms of the credit are met

5. 5 L/C: how it works

6. 6 The Stages explained 1. Exporter and buyer agrees on this way of payment 2. Buyer (applicant for the credit) instructs a bank at his place of business (issuing bank) to open a L/C for the exporter (beneficiary) on buyer’s terms

7. 7 The Stages explained 3. Issuing bank arranges with a bank at the locality of the exporter (advising bank) to negotiate, accept and pay the exporter’s draft upon the delivery of the transport documents by the seller 4. Advising bank informs the exporter that it will negotiate, accept or pay his draft upon delivery of documents. Advising bank may do so without its own engagement or it may confirm the credit opened by the issuing bank Note: If the bank is present in both places, stages 3 & 4 are combined

8. 8 The Stages explained Stages I & IV are important for the exporter If everything is correct before the expiry of the credit, there is a binding undertaking of the issuing bank if the credit is irrevocable & also of the confirming bank if it is confirmed to the beneficiary to pay the price

9. 9 L/C: further info When an exporter asks for payment by L/C, he is transferring the risk of non-payment by the buyer to the issuing bank (and the confirming bank if the L/C is confirmed), providing the exporter presents the required documents in strict compliance with the credit An importer should only be thinking of opening a L/C if his country’s exchange control regulations require it or if his supplier insists upon it Over 50% of L/C are rejected on 1 st presentation, which can cause expensive delays for both the exporter and importer. Up to one half of these rejections could have been avoided if more care was taken to ensure the credit properly represented the sales contract

10. 10 Types of Letter of Credit according to conditions Revocable A revocable L/C can be amended or cancelled at any time by the importer without the exporter’s agreement (unless documents have been taken up by the nominated bank). Little protection is offered to the exporter with a revocable L/C and they are rarely used

11. 11 Types of Letter of Credit according to conditions Irrevocable An irrevocable L/C can neither be amended nor cancelled without the agreement of all parties to the credit. Under UCP600 all L/C are deemed to be irrevocable unless otherwise stated. Here, the importer’s bank gives a binding undertaking to the supplier provided all the terms and conditions of the credit are fulfilled.

12. 12 Types of Letter of Credit according to conditions Unconfirmed An unconfirmed L/C is forwarded by the advising bank directly to the exporter without adding its own undertaking to make payment or accept responsibility for payment at a future date, but confirming its authenticity

13. 13 Types of Letter of Credit according to conditions Confirmed A confirmed L/C is one in which the advising bank, on the instructions of the issuing bank, has added a confirmation that payment will be made as long as compliant documents are presented. This commitment holds even if the issuing bank or the buyer fails to make payment. The added security to the exporter of confirmation needs to be considered in the context of the standing of the issuing bank and the current political and economic state of the importer’s country. A bank will make an additional charge for confirming a L/C. Confirmation costs will vary according to the country involved, but for many countries considered a high risk will be between 2%-8%. There also may be countries issuing L/C which banks do not wish to confirm - they may already have enough exposure in that market or not wish to expose themselves to that particular risk at all

14. 14 Some details: Revocable and unconfirmed: not widely used, may be amended/canceled, issuing bank has to reimburse, are cheaper Irrevocable and unconfirmed: usually issued by American or British banks that consider local confirmation unnecessary, are cheaper, but do not localize the performance of the contract of sale in the seller’s country Irrevocable and confirmed: most favorable to the exporter

15. 15 More details Confirmation as localization devise: confirmed credits are means of localizing the all- important payment obligation of an export transaction in the seller’s country Variants of confirmation: -Seller’s confirmation: an arrangement under which the bank charges for confirmation have to be borne by the beneficiary (seller) and not the applicant for the credit (buyer) as is normally the case -Soft confirmation: a conditional and not definite and absolute undertaking of the advising bank

16. 16 A little bit of law 2 principles are important: A.AUTONOMY OF THE CREDIT B.DOCTRINE OF STRICT COMPLIANCE Documents should be checked if they comply with the mandate & the banks should not go beyond this

17. 17 A little bit of law Discrepancy of documents – 2 situations: 1.Ambiguity in the credit instructions: the bank should ask for clarification, if not, the bank is protected if it acted reasonably 2.Ambiguity with respect to the tendered documents: the bank should not ask identical documents when they are almost the same and not necessarily reject them, but the margin for interpretation is narrow

18. 18 Examples of transport documents Marine / ocean bill of lading (Art. 23) Non-negotiable sea waybills (Art. 24) Charter party bill of lading (Art. 25) Multimodal transport (Art. 26) Air transport documents (Art. 27) Road, rail and inland waterway transport documents (Art. 28) Courier and post receipts (Art. 29) Transport documents issued by freight forwarders (Art. 30)

19. 19 Types of L/Cs Payment at sight – payment against documents Deferred payment credit – payment at some future date according to the terms of the credit Acceptance credit Negotiation credit

20. 20 Types of L/C according to they way they work Standby L/C: A standby L/C is used as support where an alternative, less secure, method of payment has been agreed. They are also used in the USA in place of bank guarantees. Should the exporter fail to receive payment from the importer, he may claim under the standby L/C. Certain documents are likely to be required to obtain payment including: the standby L/C itself; a sight draft for the amount due; a copy of the unpaid invoice; proof of dispatch and a signed declaration from the beneficiary stating that payment has not been received by the due date and therefore reimbursement is claimed by letter of credit. The ICC publishes rules for operating standby L/C - ISP98 International Standby Practices (ICC Publications 590).

21. 21 Standby L/C (continued) Undertaking by a bank to make payment to a 3 rd party (beneficiary) or to accept bills of exchange drawn on him, provided that he complies with the stipulations of the credit which, in international trade transactions, invariably include the tender of one or several documents Intended to protect the beneficiary in the case of default of the other party to the underlying contract Functionally similar in effect to a bank guarantee or performance bond

22. 22 Types of L/C according to they way they work Revolving L/C: The revolving credit is used for regular shipments of the same commodity to the same importer. It can revolve in relation to time or value. If the credit is time revolving once utilized it is re-instated for further regular shipments until the credit is fully drawn. If the credit revolves in relation to value once utilized and paid the value can be reinstated for further drawings. The credit must state that it is a revolving L/C and it may revolve either automatically or subject to certain provisions. Revolving L/C are useful to avoid the need for repetitious arrangements for opening or amending L/C.

23. 23 Revolving L/C (continued) Used when buyer is a regular customer of the exporter, the buyer arranges a revolving credit in favor of the latter There is no renewal A corollary to a sole distribution agreement Is not the same as an Evergreen Credit** ** A Revolving Credit arrangement in which the borrower periodically renews the debt financing rather than having the debt reach maturity. Example: In a normal debt- financing arrangement, company-issued bonds or debentures have a maturity date and require principal repayment at some future point in time. An evergreen funding arrangement allows a business to renew its debt periodically, pushing back the maturity date each time so that the time until maturity remains relatively constant while the arrangement is in place

24. 24 Types of L/C according to they way they work Transferable L/C A transferable letter of credit is one in which the exporter has the right to request the paying, or negotiating bank to make either part, or all, of the credit value available to one or more third parties. This type of credit is useful for those acting as middlemen especially where there is a need to finance purchases from 3rd party suppliers.

25. 25 Types of L/C according to they way they work Back-to-Back L/C A back-to-back L/C can be used as an alternative to the transferable L/C. Rather than transferring the original L/C to the supplier, once the L/C is received by the exporter from the opening bank, that letter of credit is used as security to establish a second L/C drawn on the exporter in favor of his importer. Many banks are reluctant to issue back-to-back L/C due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to higher risk than under the original credit.

26. 26 Back-to-back (continued) Used in external trade when a merchant buys the goods in one overseas country and sells them in another and also in the string contracts (same goods are resold by several middlemen before being bought by the ultimate purchaser) The confined credit opened by the ultimate purchaser in favor of his immediate seller is used by the latter as security for his supplier Overriding credit: the credit to be opened by the ultimate purchaser

27. 27 Packing credits, red clause credits Anticipatory credit intended to assist the exporter in the production or procurement of the goods sold A convenient method for small exporter who is not familiar with shipping practice Red Clause: when advising the exporter, the bank inserts this clause into the letter of advice and is prepared to honor the exporter’s sight drafts to a certain amount against production of the stipulated documents (are not used very much anymore)

28. 28 Anomalous L/C situations L/C and bank indemnities If the seller tenders non-conforming documents, the advising bank may decide no to refuse, but instead may ask the seller to supply an indemnity and thus make the credit available When advising bank is not identical with exporter’s bank, it will ask for an indemnity from exporter’s bank This is when there are discrepancies between the docs presented and the instructions received Payment under reserve Banks may choose to do so for clients with good standing and the discrepancies are unimportant

29. 29 UCP600 Uniform Customs and Practice for Documentary Credits Most L/C are subject to UCP600, which are the universally recognized set of rules governing the use of the documentary credits in international trade. UCP were originally formulated in 1933 by the International Chamber of Commerce (ICC). All definitions and general documentary requirements referred to in this briefing are in accordance with UCP600 unless otherwise stated (in some instances, this may differ from national law). It is recommended to use L/C which are subject to UCP600 It is important to negotiate, at contractual stage if possible, which party will bear bank charges. Remember that on a small transaction, these may be totally out of proportion and, if the costs are not included in the price, profit may be eroded In UK UCP does not have the force of law or the status of custom and apply to parties that have incorporated them into contracts

30. 30 Recap p. 1 Ordering party Issuing Bank Beneficiary Advising/Confirmin g Bank 1. Signing the Contract 2. Request 3. Opening the L/C 4. Advice The seller and the buyer conclude a contract stating that payment will be made my mean of a L/C The buyer requests its bank (issuing bank) to open a L/C Issuing bank opens the L/C and sends notification to the advising bank asking to send an advice to the beneficiary Advice sent to the beneficiary informing him that there is a L/C opened in his favor Opening the L/C

31. 31 Recap p. 2 Ordering party Issuing bank Beneficiary Advising / Confirming bank 1. Goods are sent over 2. Documents 3. Payment Payment Documents Payment Resources are offered to the issuing bank for payment before the L/C is opened or, in case the L/C is not covered, the bank asks for the money when the payment is done Using the L/C Goods are sent over to the Buyer (after the Beneficiary receives the L/C and is sure it corresponds to the requirements of the underlying contract and it must perform under it) 2. L/C Docs are passed to the Advising / Confirming bank 3. Docs are verified by the Confirming / Advising bank and if they fully correspond to the requirements of the L/C, it pays the beneficiary

32. 32 Demand Guarantees vs. L/C A Demand Guarantee is very similar to a Letter of Credit except that the demand guarantee provides much more protection. For instance, the L/C provides protection only against non-payment, whereas a Demand Guarantee can provide protection against non- performance, late performance and even defective performance.

33. 33 L/C: Recommendations for exporters (1) Be sure you have to use a L/C. Consider the following: Is it a legal requirement in the importing country? What is the value of the order (i.e. bank charges > value of goods)? ‘Always Traded This Way’ (using L/C for a customer/region) without re-assessing the reasons for requesting this method of payment Importer’s credit rating; new customer vs. established trading relationships? Importing country’s risk (would a confirmed L/C be more suitable)? Issuing bank’s standing (would a confirmed L/C be more suitable)? What is the usual practice in trading with that particular country and goods?

34. 34 L/C: Recommendations for exporters (2) Are there any other measures that could be taken to protect the exporter (ex. credit insurance)? Insistence by a Credit Insurer to trade on L/C terms with buyers in certain markets. Recommendation by banks who may advise that the best method of payment is a ‘confirmed irrevocable L/C’ irrespective of the country, strength of issuing bank and without much regard to the value of the consignment. Strategic Decision Made by the Exporter - however, this strategy should be flexible to adapt to the changing risk profile of both the country and the buyer. It is important to remember that all parties in the letter of credit transaction deal with documents, not goods